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Saturday, July 4, 2009

The Psychology Of Human Misjudgement: Over-optimism

Charlie Munger is Warren Buffett's right hand man at Berkshire Hathaway. Over the next few weekends, we'll be summarizing the text he authored titled "The Psychology Of Human Misjudgement", where he describes some of man's tendencies. By understanding and learning from these tendencies, we better equip ourselves to avoid psychological biases when investing.

Munger starts his description of man's tendency to be over-optimistic by quoting the Greek orator Demosthenes, who said "What a man wishes, that also will he believe." In addition to psychologically denying when things are going badly, man will tend to be overly optimistic when things go well.

For evidence of this tendency, Munger points to people happily buying lottery tickets despite having the odds stacked against them. People also believe in new business ideas that are often poor substitutes for efficient, existing companies.

Munger believes that while this tendency has likely been helpful for evolutionary reasons, it is best to approach issues more objectively. To do so, individuals are encouraged to make more use of the simple, high-school level, probability math of Fermat and Pascal. Munger likens avoiding the antidote to this tendency (the antidote being habitual use of probabilities) to letting natural evolution determine one's golf grip rather than taking golf lessons.